Selecting and understanding mutual funds

Oct. 1, 2000
Begin thinking about treating your financial future as an obligation that`s as immediate and important as the rent - something that really can`t be put off any longer.

Begin thinking about treating your financial future as an obligation that`s as immediate and important as the rent - something that really can`t be put off any longer.

Kathleen Adams, RDH, BS

It`s interesting that in finance, as in dentistry, there can be a great deal of misconception in understanding basic terminology. Partially because certain terms have become so familiar, the public often formulates its own ideas and explanations. Think about how often patients talk about "gum disease" and the many definitions they have assigned to it.

In the financial world, many people have become familiar with the idea of investing in mutual funds. But understanding exactly how they function and how to select appropriate funds involves a larger process than most investors realize. High returns and low expenses are important, but only as part of a much larger picture (just the way improved home care is part of the process of controlling "gum disease").

Mutual fund shareholders pool their dollars with other investors who share the same investment objective. Professional money managers use the pool of money to buy a wide range of securities that can:

* Achieve a greater ownership mix in the fund`s portfolio than your dollars could working alone.

* Take advantage of investment opportunities normally available only to large institutional investors.

Mutual funds are regulated under federal and state securities laws. The Investment Company Act of 1940 requires that each fund must register with the SEC. Laws governing mutual funds require extensive disclosure to fund shareholders, the SEC, and state regulators. The laws entail continuous regulation of fund operations. However, since these regulations do not dictate the management or investment selection policies, they do not guarantee that share value will not go down.

You can cash in all or part of your shares at any time and receive, in many cases, the current value of your investment, which may be more or less than the original cost. You do not need to find a buyer; the fund is always ready to buy back (redeem) its shares. Redemptions from certain funds may be subject to a contingent deferred sales charge.

Current per-share values are calculated each business day based on the market value of the underlying securities. These values change as the values of the portfolio`s securities move up or down, and as the fund changes its portfolio by buying new securities or selling existing ones.

Selecting mutual funds

Investors who pick a mutual fund by shopping around - focusing mainly on recent fund performance - are a lot like the builder who simply gets his tools and starts hammering. A well-thought-out financial plan does for the mutual fund investor what a blueprint does for the builder. It makes "construction" easier and more successful.

Despite their distinctive characteristics - including historical performance, fund-management philosophy, and investment objectives - mutual fund investments should be chosen within the context of your overall financial plan. Examining features such as past performance aren`t where your studies should begin. The point of departure is you - your financial priorities, your resources, your approach to investment diversification, and your willingness to accept potential market volatility.

On the philosophical level, there are two basic criteria for choosing the mutual fund that`s right for you:

* Assess your financial goals (short- and long-term) and the resources you have available. Is it for something immediate, such as a down payment for a house or paying off your college loans? Or is it for funding your child`s college education or your retirement? Ask yourself how much time you have to meet your objective. Then begin thinking about treating your financial future as an obligation that`s as immediate and important as the rent - something that really can`t be put off any longer.

* Learn the investment and fund-management philosophies, as well as the objectives, of any fund you`re considering. On each of these points, you`ll have to study and compare, but they won`t be hard to find. They`re in each fund`s prospectus, a document that describes the fund in detail, including objectives, management philosophy, and past performance. If your needs are for the long term, consider funds that indicate they are managed for the long term as well. If you need income in the near term, look for funds designed to provide income for shareholders. Simply put, a fund`s investment philosophy should be similar, if not identical, to yours.

Other fund choice issues

- Past performance - Past performance can`t effectively predict future results. But, when comparing performance of funds, many experts suggest that a 10-year "window" often gives a clearer picture of historical performance. Also, because many funds focus on a particular market segment - small-growth companies, international stocks, even precious metals - it can be misleading to compare their past performance since the funds can be measurably affected by near-term "shifts" in these segments. Still, no analysis of past performance, even if it`s for a period longer than 10 years, can predict a fund`s future performance.

- Fund history - It`s the history that is not related to performance. Even the most venerable of institutions can fail, but funds that have "been around" for decades - and especially if the fund`s management remains stable for long periods of time - can offer a measure of confidence that`s important to many investors.

Clearly, there are many factors to consider and choices to be made when selecting a mutual fund, but don`t make it more complicated than it needs to be. The key is to pick a fund with a management philosophy that`s been consistent over a long period of time, as well as a fund that matches your needs and your comfort level.

Ultimately, the great controllable variable always will be the investor and in setting priorities and committing to them. Just as in periodontal health, the ultimate controllable variable is the patient and his commitment to his own dental health. By letting those priorities guide the investment-selection process, an investor can do much to ensure his or her financial future across the board.

Kathleen Adams, RDH, BS, is a financial adviser with Waddell and Reed ( She is currently trying to initiate money management workshops for hygiene students and specializes in working with dental professionals. She can be reached at (800) 210-1357, ext 7328.